The Outlook

A Trillion-Dollar Deficit?

We now expect the drop in real gross domestic product (GDP) during this downturn to be similar to the declines in 1975 (3.1%) and 1982 (2.9%), the previous record holders. In addition, we expect the unemployment rate to reach 9% in early 2010, with the real economy bottoming out in mid-2009, 18 months after the recession began.

Credit markets remain locked up. The spread between speculative-grade bond yields and U.S. Treasuries recently reached a record 1,700 basis points. Even investment-grade bonds are trading 500 basis points above Treasuries. This partially reflects unusually low Treasury yields, as international capital has flowed into the United States in search of safety despite near-zero returns.

Trade had been a support for the economy over the last two years, but that sector is turning sour. Foreign economies are dropping as fast as the United States. The stronger dollar (recently at 1.35 euros) is also cutting into export strength. Although imports are expected to drop even farther than exports, the drop in exports will prevent the trade sector from helping out the economy very much.

The stimulus package winding its way through Congress gives some excuse for optimism, though mostly for the second half of this year. Incoming President Barack Obama has proposed a package concentrating on infrastructure spending and with about $300 billion in tax cuts, apparently intended to make the package more palatable to Republicans, and $200 billion in assistance to state governments with perhaps a focus on Medicaid.

The exact contents of the package remain unclear, but it will clearly be the biggest stimulus ever, and will lead to the first trillion-dollar deficit (and perhaps $2 trillion). The total cost of the various U.S. government and Federal Reserve packages so far exceeds $3 trillion, although much of that is not included in government outlays or the deficit calculation.

CONSUMER HANGOVER

Consumers have become the weak spot in the economy after supporting it for so many years. But with the saving rate averaging less than 1% from 2002 to 2007 and home prices now subtracting from wealth instead of adding, consumers are beginning to back away from their free-spending ways. We expect the saving rate to jump temporarily to 5.8% this year, as taxpayers hoard much of their rebate checks, but then it should drop back to an average of 3% from 2010 through 2012.

Autos have been the hardest-hit area. The 10.3 million annualized selling pace in the fourth quarter was the weakest since the summer of 1982, and the 13.2 million sold in 2008 were the weakest since 1992. It is hard to know how much of the recent slump in car sales has been due to drivers not wanting to buy or lenders not wanting to lend. The high gasoline prices last summer kept buyers out of dealer showrooms. Although gasoline prices have since come down, consumers donât quite believe it yet and are remaining cautious. In addition, many potential buyers with poor credit ratings have been pushed out of contention by the tighter credit standards enforced by the auto dealers and finance companies, whose access to credit has been curtailed.

The government funds being shoved into the car companies might ease some of that problem and could lead to a quicker rebound in car sales than we expect. We currently forecast 10.3 million unit sales in 2009, which would be the weakest calendar year since 1970.

Housing-related purchases have also been soft. Furniture and appliance sales have dropped because they are often tied to the purchase of a new home. With home sales down, so are furniture and appliance sales. Recently, other big-ticket items â including electronics â have also begun to weaken, which reflects both the new caution among buyers as well as difficulties in borrowing money. On a positive note, household debt has begun to decline as a share of disposable income, and we expect this to continue.

Payrolls declined every month in 2008, and the total job loss of 2.8 million was the worst since monthly data began (1945). The unemployment rate rose to 7.2% in December, its highest level since 1993 but still moderate compared with past recessions. The rate has risen from 4.4% in March 2007, and we expect it to continue to climb to 9% in early 2010. Note that the unemployment rate is not likely to peak until at least six months after the economy starts to recover.

The job outlook is reflected in the weak consumer confidence data. Confidence is very low compared with other recessions that were statistically much worse than the current one; we expect this downturn to challenge the record decline of 1975 before it is over, however.

On the positive side, consumers will get a significant check from the Treasury, about half of which is likely to be spent. The drop in oil prices since last summer gives consumers another $200 billion of purchasing power, and we think consumers will spend it. The surge in mortgage refinancings has added to household purchasing power as well.

Unlike the refinancings earlier this decade, homeowners arenât taking cash out of their homes, but they are cutting their monthly payments.

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